The yen rallied sharply from two-week lows against the euro on Tuesday after a European official said markets may need time to digest policymakers' message that a stronger yen versus the euro is desirable.

The weekend G7 meeting in Singapore made no mention of yen weakness in its post-meeting communique, but some European and Japanese policymakers on the sidelines of the gathering said the yen should reflect fundamentals.

Investors are puzzled by mixed messages on the Japanese currency's weakness, with Japanese Finance Minister Sadakazu Tanigaki saying the euro/yen was not specifically discussed at the meeting.

Analysts also say hawkish comments from the European Central Bank are working to push the euro higher.

They are obviously trying to talk the yen up and the euro down, but this is inconsistent entirely with the rhetoric from the ECB which is indicating strongly to the market that they would raise rates, said Derek Halpenny, currency economist at BOTM-UFJ in London.

By 0845 GMT, the euro had fallen as low as 149.08 yen, down almost 0.4 percent on the day. It had hit a two-week peak in Asian trade as investors focused on the euro area's favourable interest rate outlook.

The euro hit a record high against the yen last month at 150.78 yen, according to Reuters data.

The dollar also fell to the day's low of 117.60 yen, around a quarter percent down on the day.

Against the dollar, the euro was down around a third of a percent at $1.2666.

In comments made after the G7 gathering, Tanigaki seemed to back a strong yen, saying recent moves had been a bit wild.

I'm little surprised that Japan has agreed to this. Europe seems to persuade Japan into talking the yen up. If you are struggling to get inflation back currency weakness is good, HBOS chief currency strategist Steven Pearson said.

ZEW AHEAD

The euro has found support in recent days from a barrage of hawkish ECB comments.

ECB Governing Council member Guy Quaden was quoted as saying the ECB is on high alert over risks to price stability, a goal that does not run counter to supporting growth.

The ZEW economic expectations indicator, due at 0900 GMT, is seen falling to -7.8 for September from a five year low of -5.6 in August, but the current conditions component is expected to rise to 35.0 from 33.6.

There is some speculation of a weak number coming out the ZEW today, but we are looking for a rise to 35.0, Bank of America currency strategist Kamal Sharma said.

Analysts said the ZEW was ultimately unlikely to shake expectations for further euro zone monetary tightening from the current 3.00 percent, given the plethora of hawkish ECB comments from ECB officials.

STEADY FED

Interest rates were seen remaining as the dominant theme on currency markets, with drag on the yen seen coming from its low rates of 0.25 percent, compared with 3 percent in the euro zone and 5.25 percent in the United States.

Despite chatter suggesting yen weakness from this weekend's G7 summit, the theme of carry trades wins the day, said currency strategists at Morgan Stanley in a note to clients.

This week's big event is the Federal Reserve's policy meeting on Wednesday for clues on the U.S. rate outlook. The Fed is widely expected to stand pat at 5.25 percent but keep a bias toward lifting rates further with inflation still elevated.

One senior euro zone monetary source told Reuters on Monday that rates would probably reach 4 percent next year if growth stayed as strong as expected.

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